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Comparison sites are forcing businesses and economists to rethink price theories

Comparison sites are forcing businesses and economists to rethink price theories

The competition and Markets Authority (CMA) published a report about Price comparison sites at the end of last month. They seem simple enough, but these straightforward sites raise interesting issues for economics.

Overall, the CMA was pretty positive about the DCTs – digital comparison tools, to give them their Sunday best name. The conclusion was that “they make it easier for people to shop around, and improve competition – which is a spur to lower prices, higher quality, innovation and efficiency”.

DCTs offer two main benefits. First, they save time and effort for people by making searches and comparisons easier. Second, they make suppliers compete harder to provide lower prices and better choices to consumers. In short, they bring the real world closer to the perfectly informed consumers and perfectly competing firms in the ideal world of economic theory.

But even in this market, there is an issue which goes right to the heart of much of the information which can be accessed through the internet: how do we know whether we can trust it?

The main problem is that the comparison sites typically provide their services free of charge to consumers. They make money by charging a commission to suppliers.

This creates an incentive for a DCT to promote those suppliers which pay it the most commission. An effective way of doing this on the internet is by the order in which the information on the various suppliers is presented.

It is not that DCTs deliberately provide misleading information, or even that a site leaves off a major supplier which does not pay the particular website enough. But they can put those that pay the most at the top of the list.

Notoriously with Google searches, people rarely click through to anything which is not in the top three results of the search.

Allegedly, 60 per cent of the time, only the site which comes at the very top of is accessed.

Obviously on a DCT, consumers are likely to look at more. That is the whole point of using the site. But although the CMA does not provide hard data on this, it expresses a clear concern about the ways in which the sites rank the suppliers.

How the DCTs themselves set their prices raises a more general question for economics. The basic rule, described in the textbooks since time immemorial, is to set price equal to marginal cost – in other words, at the point where the revenue from one extra sale equals the cost of producing that extra item.

The standard assumption made in teaching generations of students their introductory course to economics is that as the level of output increases, marginal cost first of all falls but eventually rises.

But on the internet, once the site is set up, the cost of dealing with an extra user is effectively zero. The time-hallowed formula of economics is a recipe for bankruptcy.

The internet is forcing companies to innovate in their pricing strategies. And it is forcing economists to rethink some of their theories.

As published in City AM Wednesday 18th October 2017

Image: Man and Laptop by Pexels is licensed under CC by 0.0
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Behavioural economics has had its Nobel moment, but take it with a pinch of salt

Behavioural economics has received the ultimate accolade.

Richard Thaler of the University of Chicago Business School has been awarded the Nobel Prize in economics for his work in this area.

Economics over the past 20 to 30 years has become far more empirical. Leading academic journals do still carry purely theoretical articles, but far less than they once did.

This shift towards the empirical takes two forms. Major advances have taken place in the heavy duty statistical theory of analysing large scale databases containing information on individuals and their decisions. This was recognised when James Heckman and Daniel McFadden were awarded the Nobel Prize in 2000.

Behavioural economics is much less technical. In any given situation, the decision which a purely rational person would take is identified. We then look how people actually behave, and see if there are any deviations from the rational way of doing things.

Perhaps the main finding of behavioural economics is so-called prospect theory, first set out nearly 40 years ago by Daniel Kahneman. In essence, prospect theory says that people dislike making losses more than they like making gains of the same amount.

Another important discovery is that, when weighing up how to value future costs and benefits, people often place much more weight on the present and very immediate future than standard economic theory assumes. Last month I wrote about how this helps to explain the reluctance of electorates to deal with climate change.

These two results are backed by large amounts of evidence obtained in a range of different contexts. So now they are being integrated into economic theory.

But many economists are altogether less sure about much of the rest of behavioural economics. One of the issues is that it often gives the impression of being rather ad hoc. No reason is given as to why people in one situation appear to behave rationally, but in another they do not. Very few guidelines have emerged as to when we can expect to see deviations from rationality.

Another issue is that many economists are prepared to accept that non-rational behaviour might be observed at a point in time. But in a reasonably stable situation, people will learn over time to be rational.

Behavioural economics is not just about advancing knowledge on the workings of the economy. Policy-makers have become interested.

Cass Sunstein, Thaler’s colleague, served in the Obama administration as head of the Office of Information and Regulatory Affairs. David Cameron set up the so-called “Nudge Unit” in his government based on Thaler’s ideas. Thaler claimed 10 years ago that a “nudge” could lead to “better investments for everyone, more savings for retirement, less obesity, more charitable giving, a cleaner planet, and an improved educational system”. In his 2016 book Misbehaving, he has backed off the extravagance of these claims.

Still, whatever the doubts and qualifications, behavioural economics has made a big impact. An economist can no longer be said to have a good training if he or she is not familiar with its main themes.

As published in City AM Wednesday 11th October 2017

Image: Richard Thaler by Chatham House is licensed under CC by 2.0
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Anti-capitalists in UK universities need a refresher course in the perils of socialism

Anti-capitalists in UK universities need a refresher course in the perils of socialism

The great Harvard economist Joseph Schumpeter, writing in the 1940s, predicted the eventual demise of capitalism. He did not want this to happen. But he envisaged that the “intellectual class” would eventually develop values which were hostile to free markets and private property.

Schumpeter’s definition of “intellectuals” was very wide. He meant people in a position to develop critiques of the economy and society, but who were themselves not responsible for running them.

The social science and humanities departments of almost all British and American universities fit this description perfectly. Even though capitalism offers them a standard of living far superior to that of any alternative system, they appear only too keen to undermine it.

The idea pervades these departments, for example, that the prosperity of the West depends upon slavery. It is this which underpins the current fashion for wanting to pull down statues of historical figures, including Britain’s greatest naval hero, Admiral Nelson.

One of the things on which the success of the West actually does depend is what we might call the empirical mode of thought. Put more simply, a theory is only any good if it is tested successfully against real life evidence.

Slavery still exists even today. In Mauretania, slavery was not abolished until 1981. Today, 1 in 25 of the entire population are estimated to be slaves. Yet Mauretania is not rich. Indeed, it is one of the poorest countries of the world.

For thousands of years, slavery has been widespread. The economy of the Roman Empire was essentially based upon stupendously large estates, all worked by slaves.

Yet none of these societies ever became rich. It is only under capitalism that this has happened. So the idea that slavery makes a society prosperous is rejected very decisively by the evidence. But this does not stop it from being almost an article of faith amongst many British academics.

Ludicrously, many of these people describe themselves as “socialists”.

The point simply cannot be made too frequently that we have seen several major natural experiments, which contrast the empirical performances of economies based upon market oriented principles with those based upon the planned economy principles of socialism.

The United States and the Soviet Union, West and East Germany, South and North Korea, India and China under different forms of socialism until the 1980s and India and China under different forms of capitalism since then. Venezuela is but the latest example. Capitalism wins decisively in every single case.

Countries such as South Korea which were very poor in the mid-20th century and which have adopted the principles of market oriented economics have since flourished.

Economists enjoy arguing amongst themselves. But the profession in general believes in private property and markets as the basis for prosperity. Empirical studies, rather than pure theory, have become much more important within economics in the past 20 to 30 years.

Economists need to take a bit of time out to confront their common enemy. Namely, the unscientific output of many social science departments in British universities.

As published in City AM Wednesday 6th September 2017

Image: Berlin Wall by US Dept of Defense is licensed under CC by 2.0
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Thomas Schelling – a true polymath of genius

Thomas Schelling – a true polymath of genius

Thomas Schelling is probably best known in economics for his contributions to game theory. Indeed the citation for his 2005 Nobel Prize states it was for “having enhanced our understanding of conflict and cooperation through game theory analysis”.

In the early, tense years of the Cold War between America and the Soviet Union in the late 1940s and 1950s, the US government invested heavily in the then new science of game theory. Schelling’s ideas were enormously influential in preventing nuclear conflict from breaking out. The opening lines of his Nobel Prize lecture point out the real danger that existed: “The most spectacular event of the past half century is one that did not occur. We have enjoyed sixty years without nuclear weapons exploded in anger”.

How do you handle a weapon which is so devastating you do not want to use it, whilst at the same time you must convince the other side that you might? Schelling was instrumental in creating the strategy of credible threats.

His Nobel lecture focused exclusively on game theory, the area par excellence of rational agent behaviour. This was a rather curious decision on his part.  For his mind ranged powerfully over a wide range of issues.

Schelling made seminal contributions both to complex systems theory and to the rigorous  analysis of agent behaviour on networks. It took time for scholars to appreciate the importance of this work. But these two themes are now at the forefront of science in the 21st century.

His 1971 paper in the Journal of Mathematical Sociology, entitled “Dynamic Models of Segregation”, was a brilliant illustration of the principle of emergence in complex systems. Schelling postulated a giant chessboard populated by an equal number of two types of agent located at random, and a few vacant squares. Each agent has a very weak preference for being in a majority in its local neighbourhood. This latter concept can be defined in a number of ways, but the simplest is the eight immediately adjacent squares plus the square the agent is on.  If only four of its neighbours are of its own type, and four are not, the agent is happy. But  if it is a minority, it moves at random to an empty square.

Although the individual preferences for location are weak, the board segments rapidly into a highly segregated pattern, with blocks of agents all of the same type. As Schelling puts it: “The systemic effects are overwhelming: there is no simple correspondence of individual incentive to collective results”. In other words, the properties of the system emerge from the interactions of the individual agents.

Schelling described the “analytics of neighbourhood tipping”, and stated that “a general theory of tipping begins to emerge”.  Nowadays, of course, the phrase “tipping point” is in common parlance, not least because of Malcolm Gladwell’s popular book on the topic, written thirty years after Schelling’s paper.

Our understanding of crime, obesity, smoking, binge drinking – a whole host of social problems – has been improved substantially by Schelling’s work. He saw that there are underlying similarities in how they develop.

His most important work in this area was published in 1973, in a paper in the Journal of Conflict Resolution with the wonderful title “Hockey Helmets, Concealed Weapons and Daylight Saving”. Schelling’s inspiration was a piece in the sports section of a newspaper about ice hockey, a game even more brutal than Rugby League.

A star player had suffered serious head injuries from the flying puck whilst not wearing a helmet. The reporter interviewed other leading players, none of whom wore helmets. It was clear that they understood the very real dangers involved.  A rational economic person, weighing up the costs and benefits, would always wear a helmet. But when asked why not, a top boy answered “I don’t because the other guys don’t”.

Schelling crystallised this into a mathematical concept he called “binary choice with externalities”. The choice facing an individual is binary. Either you wear a helmet or you don’t. Either you smoke, or you don’t. But your choice may affect how other people in your peer group make their choices. If no one else wears a helmet, you look soft by wearing one. If all your friends smoke, you may do so just to fit in. So the decision of an individual can have effects which are “external” to the decision itself. Understanding this is crucial to policy makers trying to influence the outcome. Rational choice theory may not always apply.

Schelling’s segregation paper was all the more remarkable because, nearly five decades ago, he essentially had to work out its properties by hand. In the same way, the concept of binary choice with externalities was set out with diagrams.

Advances in computer technology enabled the mathematical sociologist Duncan Watts to develop the idea dramatically in a 2002 paper entitled “A Simple Model of Global Cascades on Random Networks”. Agents in the Watts model, as in the original Schelling piece, take no account of the attributes of the alternatives facing them. Instead, they select using a variety of rules, all based on the principle of the choices made by agents to which they are connected. At the start, all agents are in the same state of the world. A small number is selected to switch the other. Watts analyses and simulates the cascade properties – how many will eventually switch – when agents are connected on different types of network.

Schelling made strikingly powerful and original contributions in a range of disparate areas. Much of his work was decades ahead of its time. Overall, he was a true polymath of genius.

As published in the Royal Economic Society newsletter April 2017

Image: Thomas C. Schelling by New America is licensed under CC by 2.0
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